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1. Background and Context

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1. Background and Context

Chapter Highlights

 The World Bank Group has broad strategies to support trade and financial sector development that include support for the supply of trade finance flows in emerging markets.

 A range of trade finance instruments provided by the banking sector supports liquidity and risk mitigation in global trade transactions.

 The trade finance industry is characterized by short-term credit maturities and relatively low risk of default and is dominated by some 30 international banks.

 Trade finance recovered after the global crisis, although gaps in market coverage remain and changes in the industry are taking place.

The World Bank Group’s Strategy to Support Trade and Financial Intermediation

There are well-established links between trade and economic development. According to the World Bank Group, no country in the last 50 years has increased per capita incomes without expanding trade with the rest of the world (World Bank 2011b). In the last few decades, significant trade liberalization undertaken by

developing countries has resulted in faster growth and substantial reductions in poverty.1 Open trade enables countries to exploit their comparative advantage, create competitive industries, specialize and develop economies of scale, improve resource allocation efficiency, and generate economic opportunities and

employment (see, for example, Dollar and Kraay 2003; Berg and Krueger 2003). Key measures to open the economy and catalyze private sector–led, export-oriented growth in many developing countries have included removal of price controls, subsidies, and disincentives to export; elimination of nontariff barriers;

rationalization and reduction of tariffs; customs reform; and improved foreign exchange regimes. Experience in developing countries has indicated that for trade reforms to be effective they need to be implemented alongside other policies and investments that affect productivity and growth, including development of

infrastructure, the business environment, the financial sector, and maintenance of macroeconomic stability through prudent fiscal and monetary policy (see Hallaert 2010; Hoekman 2010; IEG 2011a).

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trade-stifling regulations and policy disincentives.2 The initiative led to the

establishment of the Aid for Trade Program of the World Bank Group that sought to help countries maximize and leverage trade opportunities by enhancing

competitiveness (Hoekman 2010). The program encompassed a range of Bank

Group initiatives to support trade, including Bank lending for trade-related projects; investments by the International Finance Corporation (IFC) in private sector

activities such as trade finance, policy advice and technical assistance, and

knowledge generation activities such as the Diagnostic Trade Integration Studies in low-income countries (LICs).

In 2011, the Bank Group identified its priorities in supporting global trade over the next decade. The 2011 strategy document, Leveraging Trade for Development and

Inclusive Growth (World Bank 2011b), outlined areas that the Bank Group is currently

emphasizing in its support for trade in developing countries. The strategy is

premised on the central role of trade as a driver of economic growth in developing countries. Its main objectives are to help enhance trade competiveness and export diversification; reduce trade costs; expand market access; improve management of shocks; and enable greater participation in trade activities (see Figure 1.1). Progress toward each of these objectives is considered critical to attaining the overall goal of enhancing trade in developing counties. Among the interventions is support for the provision of trade finance, which is identified in the strategy as helping reduce trade costs, but can also help increase access to finance as well as mitigate shocks that can affect trade flows.

The Bank Group also emphasizes the importance of a well-functioning financial sector in developing countries. Support for trade finance is a financial sector intervention and therefore also forms part of the Bank Group’s efforts to support financial sector development. According to the Bank Group’s strategy, when financial markets work well, they channel funds to the most productive uses and allocate risks to those who can best bear them, thereby enhancing productivity and expanding economic opportunities.3 In contrast, when financial markets do not work effectively, they hinder growth and accentuate inefficiencies and inequality of opportunity (IFC 2012a). Weaknesses in financial intermediation in developing countries include small domestic financial markets, a narrow range of instruments, undeveloped nonbank financial institutions, undeveloped capital markets, and limited reach of financial services. These weaknesses are often caused less by the unavailability of funds and more by factors such as unsound macroeconomic policies, inadequate regulatory framework, poor quality contractual and regulatory institutions, and ineffective transactional and informational infrastructures.4

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Figure 1.1. The World Bank Group’s Strategy to Support Trade, 2011–21

Source: IEG, based on World Bank 2011b.

The Bank Group aims to help establish effective financial systems and expand access to finance. The Bank Group’s objectives in the financial sector have been to help (i) establish the legal and regulatory foundation for financial services, (ii) build market and institutional infrastructure (such as contract enforcement, payment systems), (iii) foster the diversity of the financial system, (iv) develop capital markets, and (v) improve access by the poor and micro, small, and medium-size enterprises (MSMEs) to financial services. The Bank supports achievement of these objectives through policy lending, financial intermediary lending, and its analytic and advisory activities. IFC supports development of local financial markets through institution-building, financial products, and mobilization that emphasizes access to finance among MSMEs. IFC’s strategy in financial markets has involved (i) working alongside the Bank to create supportive policy, legal, and regulatory frameworks; (ii) investing and providing technical assistance to financial institutions; and (iii)

ECONOMIC GROWTH AND POVERTY REDUCTION Improved economy‐ wide incentive framework Increased access to  trade finance Expanded benefits of  trade to lagging regions  within countries INCREASED TRADE Expanded Market  Access Specific actions to  address market failures Improved markets for  transport and  logistic  services Improved trade corridors  and regional trade facilitation  frameworks Improved regional  integration of markets  Improved international  trade rules and institutions Inclusion of the gender  dimension in trade  support activities Increased trade in 

services Improved border management

Source:  IEG, based on Leveraging Trade for Development and Inclusive Growth:  The World Bank Group Strategy 2011‐2021, June 2011 THE WORLD BANK GROUP’S STRATEGY TO SUPPORT TRADE, 2011‐2021 Improved response to  food price increases and  volatility Reduced Trade Costs Reduced costs associated with moving  goods and services along international  supply chains, including transport,  logistics, and finance costs Enhanced Trade  Competitiveness and  Export Diversification Increased value of exports Increased # of export markets Improved survival rate of exporters Effective Management  of Shocks and Increased  Opportunities to  Participate in Trade Improved inter‐ governmental regulatory  reform and cooperation  Better management of  trade shocks by most  vulnerable

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The Role of Trade Finance

Much of international trade is conducted directly between firms, without

intermediation from the banking sector. Total world merchandise trade in 2011 was valued at $18 trillion (WTO 2012). Of this, it is estimated that some 80 percent is conducted between firms without direct intermediation of the banking sector.5 Transactions that are conducted directly between firms can involve cash in advance from the buyer to the seller or can be done on an open account basis, with the buyer paying the seller at a later point. The cash in advance option is safest for the

exporter, but may not always be available in competitive markets, where the importer may have a choice of sellers.

An open account transaction is more favorable to the importer. The exporter ships the goods and then collects payment on delivery or at another point. In this case, the exporter bears the risk of non-payment by the importer. Studies estimate that direct cash in advance payments are most prevalent among small and medium-size

enterprises (SMEs) in developing countries, whereas open account transactions tend to be used in more developed, competitive markets (Chauffour and Malouche 2011; IMF and BAFT 2009).

Trade finance provided by the banking sector supports liquidity and risk mitigation in trade transactions.6 In addition to making payment arrangements directly

between themselves, importers and exporters can use the banking sector to intermediate a transaction. Such intermediation can reduce risk, improve the liquidity and cash flow of the trading parties, and provide locally oriented firms with access to hard currency needed to finance imports (Chauffour and Malouche 2011). Some 20–40 percent of world trade is estimated to be intermediated in this manner. The choice of direct or banking sector-intermediated trade will depend on the familiarity and degree of trust between the buyer and the seller, as well as broader country, sector, and institutional factors that increase or decrease the risk of nonpayment for the goods and services being traded.

The most common type of trade finance instrument is the letter of credit. Several types of instruments exist for banks to intermediate trade transactions. The most prevalent is the letter of credit that was used in some 15–20 percent of world trade transactions in 2011.7 A letter of credit can be either unconfirmed or confirmed. In an unconfirmed letter of credit transaction, an importer requests a local bank to issue the letter of credit in favor of the exporter. The local bank (“issuing bank”) then issues a letter of credit through which it irrevocably agrees to pay the exporter on agreed terms (such as presentation of relevant documents). In this transaction, there is only one bank that is financially involved—the bank that issues the letter of credit. The exporter takes the risk that the local issuing bank will not honor its obligations (for example, because of credit or country events). Such unconfirmed letters of credit

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are more common when the local issuing bank has a strong balance sheet and is in an economically and politically stable country.

A confirmed letter of credit transaction is often used in trade between developed and developing countries. In a confirmed letter of credit transaction, a second bank (the confirming bank), usually in the exporter’s country or region, is also involved. If an exporter is unwilling to take the payment risk of the local issuing bank, then it can request that a second bank add its commitment (or confirmation) that payment will be made to the exporter. A confirmed letter of credit is generally used when there is a perception that there is a risk that the local bank issuing may not fulfill its obligation to pay for any reason, including bank failure, country instability, or country regulations. In this case, the confirming bank takes the payment risk of the local issuing bank in the country of the importer.

For a confirming bank to take the payment risk of the local issuing bank, it has to establish a relationship with the issuing bank, conduct its due diligence on the bank, and establish a prudential credit limit, up to which it is willing to be exposed to this bank. As discussed below, the majority of transactions (70 percent) involving IFC’s Global Trade Financing Program (GTFP) involve confirmed letters of credit (with the balance supporting other instruments, such as pre-export and pre-import finance).

Other trade finance instruments include performance bonds and guarantees. A bank can provide a performance bond or guarantee to ensure satisfactory performance by a party under a contract, such as in a tender purchase. In these transactions, an issuing bank provides a guarantee to an importer on behalf of its client (the

exporter) that guarantees compensation in the event that the exporter does not meet specific financial or performance standards. The guarantee reduces the need for cash or other collateral from the exporter to support its performance obligations. Types of guarantees include (i) a bid guarantee, which signals the exporter’s intent to comply with the requirements of an order; (ii) an advance payment guarantee, which assures an importer that has made an advanced payment that the payment will be recoverable in the event of a performance failure on the part of the exporter; (iii) a performance guarantee, which assures compensation to an importer in the event of a financial or performance failure on the part of the exporter; and (iv) a standby letter of credit, which comes into effect only if the importer defaults after receiving the goods.

Pre-import and export loans provide working capital to trading firms. Another trade finance instrument is a pre-import loan, which is a short-term facility provided by a

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has received a purchase order that bridges the gap between processing of the order and receipt of payment. This is a common means of working capital financing when a letter of credit is used as the settlement instrument. IFC’s trade finance programs support each of these instruments.

Characteristics of the Trade Finance Industry since 2006

Several key characteristics distinguish the market for trade finance from other financial markets. The trade finance industry is characterized by short-term

maturities, with security in the underlying goods being moved in a transaction. The average tenor of a trade finance transaction in 2005–10 was 147days (4.9 months).8 The trade finance industry is dominated by 30 international banks that account for more than 80 percent of global trade finance.9 International Chamber of Commerce (ICC) surveys over the last few years have indicated that trade finance industry remains a relatively low-risk industry. Low default and loss rates and high recovery rates were reported across product types in the industry. The average default rate on import letters of credit in 2008–10, for example, was 0.08 percent, with only 947 defaults in a sample of 5.2 million transactions. Actual losses were even less, at 0.0007 percent. Fewer than 3,000 defaults were observed out of the 11.4 million transactions in the 2005–10 data sets.

The global financial crisis affected trade flows. Prior to the onset of the global economic crisis in 2008, financial markets were buoyant, there was substantial liquidity, and there were unprecedented levels of capital flows to developing countries.10 Following the onset of the crisis, both international trade volumes and trade finance volumes dropped sharply. Although there were some initial

hypotheses that the drop in trade was linked to the decline in financial liquidity, subsequent research indicates that the decline in trade was more a result of lower demand for traded goods, and the decline in trade finance was a result of the lower level of trade (Chauffour and Malouche 2011). This condition was reinforced by a shift from non-bank-provided trade finance into the safer bank-provided trade finance at a time when banks were themselves suffering a shortage of liquidity and were unwilling or unable to increase their activities. Evidence also suggests that developing countries were hardest hit by the crisis in terms of access to finance, especially firms at the margins of the formal finance networks (Malouche 2009). After the initial crisis passed, trade finance recovered, although some changes in the industry are evident. In September 2012, the World Trade Organization

downgraded its forecast for world trade expansion from 3.7 percent to 2.5 percent. According to the World Trade Organization, slowing trade growth since 2011 is linked to the rebalancing of the world economy toward domestic demand in emerging markets as well as lower growth in developed countries. Although liquidity returned to the main trade markets after 2010 and spreads have declined,

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U.S. dollar funding has remained an issue outside the United States. The industry has also shown greater selectivity in risk-taking and “flight to quality” customers. The European sovereign debt crisis is also causing some realignment of the industry. Some European banks have been under pressure to reduce leverage and have

accomplished this by selling assets, including trade finance assets, and raising capital—or “deleveraging”—to strengthen their balance sheets and regain investor confidence. A recent International Monetary Fund study showed that of a sample of 58 European Union-based banks, 24—including some of the largest global banks active in trade finance—plan to sell some $2 trillion in assets over 2011–13 (IMF 2012). Meanwhile, there are indications that U.S.- and Asian-based banks are stepping into the void being created by European banks and increasing their trade finance activities, although the extent to which they can fill the gap remains to be seen (Braithwaite 2012).

There are some views that the new Basel III framework will impact adversely on the provision of trade finance services. The changes in the Basel III regulatory

framework that are being phased in have caused the trade finance industry to point out some concerns. In particular, there are concerns that (i) banks will move away from the trade finance market into higher return products because of higher capital requirements; (ii) inconsistencies in the implementation of the regulatory regime across countries might create competitive arbitrage opportunities for some financial institutions and may impact on the domiciling of banks; (iii) by not treating trade finance as a low-risk asset class, the new Basel capital framework may unduly raise the costs of trade finance; and (iv) increasing compliance costs will further erode the narrow margins in trade finance.

Summary

 The World Bank Group has broad strategies to support trade and financial sector development that include support for trade finance flows to emerging markets.

 Intermediation of the banking sector in trade transactions can mitigate risk and improve the liquidity and cash flow of trading parties. The most common trade finance instrument that banks use to intermediate trade transactions is the letter of credit. A confirmed letter of credit transaction involves a local issuing bank and an international confirming bank that guarantee the trade transaction payment.

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 The trade finance industry recovered after the immediate effects of the global crisis, although some changes in the industry are evident: although liquidity returned, spreads have declined and U.S. dollar funding is an issue outside the United States; the industry has shown greater selectivity in risk taking and “flight to quality” customers; and the European sovereign debt crisis is also causing some realignment of the industry.

NOTES

1 IMF and World Bank, Doha Development Agenda and Aid for Trade, 2006. 2 WTO document, Ministerial Meeting, Hong Kong, 2005.

3 World Bank Group, Financial Sector Strategy, 2007. 4 World Bank Group, Financial Sector Strategy, 2007.

5 SWIFT data. There are substantial variations in the estimates. This estimate is assumed to comprise banking sector intermediation at points immediately preceding or following cross-border movement of goods or services and exclude financing further up or down the supply chain.

6 In this report, “trade finance” is treated as financing provided by the banking sector at the points immediately preceding or following the cross-border movement of goods or services. It would, therefore, exclude banking sector financing further up or down the supply chain.

7 SWIFT data.

8 International Chamber of Commerce Trade Register.

9 These banks include Bank of America Merrill Lynch, Bank of China, Barclays, BNP Paribas, Citibank, Commerzbank, Crédit Agricole, Credit Suisse, Deutsche Bank, HSBC, ING, J.P. Morgan Chase, Royal Bank of Scotland, Santander Global Banking, Standard Chartered Bank, Sumitomo Mitsui Banking Corp, UniCredit, and Wells Fargo.

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